Bonds

BONDS

Bonds are debts to the issuers, whereas they are investments to buyers. Such debts appear on balance sheets of the issuing entities as long-term liabilities. Bonds provide a source of funds for the issuer and a payment to the buyer in the form of interest. Both bonds and stocks are referred to as securities, yet the two are different types of investments.

BONDS: LONG-TERM AND VARIED

Bonds are generally considered long-term obligations. Nevertheless, since there is trading in the secondary market for some types of bonds, it is possible to buy and sell such bonds at any time. Bonds are issued by entities seeking funds for a variety of reasons.

Corporations issue bonds often for expansion purposes, when they have determined that extension of their long-term debt obligations is a better strategy than to expand their ownership base through the issuance of additional stock. Corporations are frequently motivated to choose bonds over expansion of stock owners for two basic reasons: The cost of interest is deductible as a yearly expense, and there is no dilution of ownership through the extension of the company's liabilities.

The federal government issues bonds, along with short-term notes, for the expenditures required to operate the federal government and to pay off debt that is maturing. Municipalities and states issue bonds for capital expenditures that are perceived necessary to maintain the infrastructure of the entity. Such bonds provide funds to build local roads, stadiums, schools, and other public buildings.

Investors can choose from a wide variety of bonds. Among them are: corporate bonds, federal government bonds, municipal bonds, asset-backed bonds, mortgage-based bonds, and foreign government bonds. For each of these categories, there are variations. Additionally, there are bond funds related to government bonds, corporate bonds, and foreign government bonds. It is possible to buy bonds that are convertible into stock. The bond market is indeed complex and varied. For purposes of the discussion here, the focus will be on basic bond types: corporate, federal government, and municipal. There will follow a discussion of bonds as an investment for an individual.

CORPORATE BONDS

In a corporation, the board of directors is responsible for making the decisions related to a bond issue including determining how much money is to be raised, what type of bond will be sold, what the maturity date will be, and what the interest rate will be. Corporations with sound credit standing are able to issue bonds without pledging assets. Such bonds are called debenture bonds, or unsecured bonds. Companies with low credit standing often issue secured bonds, for which specified assets have been pledged as collateral.

Issuance Process

Corporations generally do not sell directly to the public; rather, they sell their entire issues to an underwriter, often an investment bank, which acts as "middleman" for the corporation and the bondholders. (Sometimes more than one underwriter participates in the sell of an issue, especially if the value of the issue is high.) The issuing company also engages a trustee, generally a bank or trust company, to monitor the sale to ensure that all the details of the bond indenture are honored by the underwriters.

The contract for a purchase of bonds is called a bond indenture, which provides a description of the bond issue as well as the rights of both the buyer and seller. The buyer, for example, may have the right to convert a bond into stock. Sellers often state options, which modify the basic agreement. For example, a common option is the right to retire a bond before its maturity date. Such bonds are called callable bonds. Before the possibility of paperless transactions, bond certificates were issued, but now transactions tend to be book entries only.

Bonds have a predetermined rate of interest called the stated or contract rate, which is established by the board of directors. The actual interest rate, however, determined at auction, is referred to as the market rate. The market rate may equal the stated rate, or it may be higher or lower. The bond that sells at the stated rate is considered to have sold at par value. If the market rate is higher, the bond is sold at discount, which means that the buyer will pay less than the face value of the bond, therefore earning interest at a rate higher than the stated rate. If the market rate is lower, the bond is sold at a premium, which means that the buyer is paying more than the face value of the bond, and earning less than the stated rate. Although there may be a difference between stated and market rates, the actual interest paid is based on the stated rate and the face value of the bond. Interest is usually paid semiannually.

Bonds are registered in the name of the person who purchased them. The registered owner receives the interest on the interest payment date. If a $1,000 bond carried interest at a contract rate of 6 percent, the registered owner would received a check for $30 semiannually. Since electronic processing began, the book entry means that the bonder holds a virtual bond. The corporation's computer files merely contain the names and addresses of those to whom interest checks will be sent on the appropriate dates. Additionally, with the ability to transfer funds electronically, corporations are able to deposit interest payments directly into their bondholders' bank accounts.

The Nature of the Bond Market

The bond market is dominated by institutional investors, such as insurance companies, mutual funds, and pension funds, but bonds can be purchased by individual investors as well. Bonds are traded both in the primary market, which is the initial sale of the bonds, and in the secondary market, which is the sale of bonds subsequent to the initial sale by the issuer or underwriter. While the stated rate is the same throughout the life of the bond, the effective rate varies with the buying and selling of corporate bonds in the secondary market.

An investor who wishes to buy or sell corporate bonds must contact a broker or dealer who might carry that particular bond in inventory. A dealer who does not have that bond would contact another dealer who did. Many major newspapers report information about bonds, both corporate and U.S. government bonds.

Rating of Corporate Bonds

There are three organizations that rate corporate bonds: Fitch Investors Service, Moody's Investors Service, and Standard & Poor's Corporation (S&P). Each has a ranking system. For example, S&P uses AAA as the highest ranking, meaning in general that bonds so ranked are issued by corporations that are judged to have extremely strong capacity to pay interest and to repay the principal. S&P's lowest ranking is D, which indicates that the corporation's bonds are in default, and payments are in arrears. Between the two are AA, A, BBB (all indicating levels of adequate assessments), with AA being higher than A, and A higher than BBB. Bonds rated BB, B, CCC, and CC are predominately speculative, with the lower ratings often referred to as junk bonds or high-yield bonds. C is reserved for bonds no longer paying interest.

FEDERAL GOVERNMENT BONDS

The U.S. federal government borrows large amounts of money in order to meet its obligations. The U.S. Treasury issues a number of debt obligations in addition to bonds. Securities with maturity dates of less than a year are called Treasury bills (or T-bills); those with maturities from one to ten years are called notes; those with maturities exceeding ten years are generally called bonds. There are I bonds and EE bonds, however, that may be redeemed at any time after a twelve-month-minimum holding period. Collectively, the issues of the U.S. Treasury are referred to as Treasuries.

Federal government bonds are auctioned according to a schedule that is posted at the Treasury's Web site (http://publicdebt.treas.gov), after announcements at press conferences. The bonds available are varied. A description of a limited number of what is available follows:

Thirty-Year Treasury Bonds

The U.S. Treasury sells thirty-year bonds twice a year. These bonds pay interest every six months until maturity. The bondholder receives face value at maturity. Price and yield are determined at auction. Both noncompetitive and competitive bids are accepted. Choosing a noncompetitive bid means that the buyer accepts the interest rate determined at auction and the buyer is guaranteed to receive the bond in the full amount requested. Such a bid may be made through TreasuryDirect (http://www.savingsbonds.gov), a government Web site that is run by the Bureau of the Public Debt, part of the U.S. Department of the Treasury. A competitive bid requires that the buyer use a bank, broker, or dealer. With a competitive bid there is uncertainty of about whether the buyer will be accepted or, if accepted, will get the number of bonds requested. These bonds are available only in electronic entries in accounts.

I Bonds and EE Bonds

I bonds and EE bonds are not typical bonds. They are available in small denominations. They can be purchased at local banks and other financial institutions, as well as through TreasuryDirect, and sometimes through payroll deductions.

I bonds, whose rate of return is tied to the inflation rate, may be purchased in denominations of as little as $50. I bonds are a low-risk, liquid savings product. They are available through TreasuryDirect or payroll deduction, as well as at most local banks and other financial institutions. These bonds earn interest from the first day of their issue month. They are an accrual-type security, which means they increase in value monthly and the interest is paid when they are cashed. They can earn interest for up to thirty years. The I bond's interest is based on a composite rate that is a fixed rate for the life of the bond and an inflation rate that changes twice a year.

EE bonds are popular, low-risk savings products with interest rates based on a fixed rate of return. EE bonds are available at the TreasuryDirect Web site. If purchased electronically, EE bonds are sold at face value, which means the buyer pays $50 for a $50 bond. Purchases in amounts of $25 or more, to the penny, are possible.

Paper EE bonds are also available. The price is 50 percent of face value, that is, $25 for a $50 EE bond. Buyers are issued bond certificates. Paper EE bonds are purchased through local banks, other financial institutions, or through an employer's payroll deduction plan, if available.

MUNICIPAL BONDS

State, county, and local governments also borrow money by selling municipal bonds (frequently referred to as "munis"). Municipal bonds are either general obligation or revenue bonds. The principal of general obligation bonds (also known as "GOs") is paid from tax payments from citizens and from user fees for services provided by the political unit. The costs of building schools and sewers, for example, are paid for through general obligation bonds. A revenue bond is one that is issued by an enterprise for a public purpose that is expected to generate revenues, such as the building of airports, utility company infrastructure, toll roads, universities, and hospitals. The money to pay bond interest and principal at maturity will be paid by successful enterprises' revenue-generating activities.

Municipal bonds are ranked by financial information rating services. For example, the same ranking used by S&P for corporate bonds is used for municipal bonds.

BONDS AS AN INVESTMENT

Bonds are purchased by Americans for investment. Bonds are considered to be a less-risky type of investment. Bonds of the U.S. government are perceived to be the safest of all investments. Among the considerations for an investment are the following:

Risk Involved

There are several risks associated with bonds, even though there is a general belief that they are safer than, for example, investments in stocks and real estate. Among the risks are these:

Market risk:

the risk an investor faces should interest rates rise after the bonds have been purchased. As market interest rates rise, the price of bonds falls (and vice versa). All bonds—corporate, Treasury, and municipal—are subject to market risk.

Credit risk:

the risk associated with investments in corporate and municipal bonds (but not Treasuries). This risk relates to the actual creditworthiness of the issuer of the bonds. Since a bond is a loan, a bondholder has to assess the likelihood that the issuer will be able to pay the periodic interest payments and the bond's par value at maturity.

With Treasury bonds, there is virtually no credit risk since most investors see them as having the full faith of the U.S. government behind them. Because of this perceived absence of default, investors typically use the rate offered on Treasuries as the benchmark against which other investments are evaluated.

Call risk:

the risk that issuers may call back, or retire, the bonds. Such bonds may be retired when interest rates are declining. The bondholder is paid par value (and usually a small "call premium" as well) and any accrued interest since the last interest payment date. At such a time, the investor may want to replace the earlier bonds, but finds that the interest earned will be less than was the case earlier. Furthermore, if the investor had originally purchased the bonds at a premium, it is likely that the original purchase price would not be realized when the bond is called. Corporate and municipal bonds may be callable. U.S. Treasuries are not.

Tax Effects of Bond Holdings

While interest on corporate bonds is fully taxable to the bondholder, interest on Treasuries is exempt from state (but not federal) income tax. Interest on municipal bonds is exempt from federal income tax. If the municipal bond is issued by the jurisdiction in which the bondholder resides, the interest is tax-exempt from both the federal government and the state government. If there is a local income tax, the interest is tax-exempt at this level, too. Thus in some instances the bondholder has a triple exemption. Because of the tax-exempt nature of municipal bonds, their rates are usually one- to two-percentage points lower than that of a comparable taxable corporate bond, for which there is no tax exemption.

SOME GENERAL CONSIDERATIONS

Bonds typically earn a return greater than that offered by a bank on its savings account or certificates of deposit. Bonds provide certainty about the interest payments that will be received. Prices of bonds are much less volatile when compared to prices of stocks. Defaults on bonds are not common. It is also possible to buy bond funds, similar to those provided for stocks.

Much information is available at Web sites. Using such keywords terms as asset-backed bonds, bond fund, foreign government bonds, or zero bonds at a comprehensive search engine will provide descriptions and characteristics of each.

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Bonds

West's Encyclopedia of American Law
COPYRIGHT 2005 The Gale Group, Inc.

BONDS

Written documents by which a government, corporation, or individual—the obligor—promises to perform a certain act, usually the payment of a definite sum of money, to another—the obligee—on a certain date.

In most cases, a bond is issued by a public or private entity to an investor who, by purchasing the bond, lends the issuer money. Governments and corporations issue bonds to investors in order to raise capital. Each bond has a par value, or face value, and is issued at a fixed or variable interest rate; however, bonds often can be purchased for less or more than their par value. This means that the yield, or total return on a bond, varies based on the price the investor pays for the bond and its interest rate. Generally, the more secure a bond is (i.e., the stronger the assurance that the bond will be paid in full upon maturity), the less the bond will yield to the investor. Bonds that are not very secure investments tend to have higher returns. Junk bonds, for example, are high-risk, high-yield bonds. Except for the high-risk variety, bonds tend to be relatively solid, predictable investments, with prices that vary less than those of those of stocks on the stock market. As a result, litigation because of unpaid bond agreements has rarely proved necessary.

The most common type of bond is the simple bond. This bond is sold with a fixed interest rate and is then redeemed at a set time. Several varieties of simple bonds exist. Municipal governments issue simple bonds to pay for public projects such as schools, highways, or stadiums. The U.S. Treasury issues simple bonds to finance federal activities. Foreign governments issue simple bonds, known as Yankee bonds, to U.S. investors. Corporations issue simple bonds to raise capital for modernization, expansion, and operating expenses.

Conditional bonds do not involve capital loans. Most of these bonds are obtained from persons or corporations that promise to pay, should they become liable. The payment is usually a nonrefundable fee or a percentage of the face value of the bond. A bail bond is a common type of conditional bond. The person who posts a bail bond promises to pay the court a particular sum if the accused person fails to return to court for further proceedings on the date specified. Once a bond payer satisfies the terms of a conditional bond, the liability is discharged. If the bond goes into default (i.e., if the obligations specified are not met) the amount becomes immediately due. Parties also can mutually decide to cancel a conditional bond.

The emergence of simple government and corporate bonds into the modern marketplace began with the economic boom of the 1920s.

Michael R. Milken: Genius, Villain, or Scapegoat?

Few business personalities have attracted as much attention—both negative and positive—as bond market financier Michael R. Milken. After earning an estimated $1.1 billion in the 1980s as the head of Drexel Burnham Lambert's securities branch, Milken fell from grace in the press and in the eyes of many investors. In 1990 the Securities Exchange Commission charged Milken with securities fraud. In U.S. district court, Milken was fined $600 million, permanently barred from engaging in the securities business, and sentenced to ten years behind bars. Some of Milken's associates believed that he had been made a scapegoat; Milken's prosecution, they argued, was little more than an attempt to pass judgment on the 1980s, sometimes cast as the decade of greed.

Milken had formerly been heralded by the Wall Street Journalas one of the century's most important financial thinkers. In the 1970s, after finishing studies at the University of Pennsylvania's Wharton Business School, Milken was early in anticipating the boom of the junk bond market. He used his understanding of trends in investment activity, along with innovative approaches, to capitalize on what he called high-reward bonds. The junk bond boom led to both Milken's ascent and his incrimination. Milken's correct assessment of the junk bond boom paid off for him. While he worked for the powerful Drexel Burnham Lambert firm, his profits made him a billionaire. But how he made those profits also led to his downfall. The government held evidence implicating Milken in manipulation of stocks, insider trading, and bribery of investment managers.

With fines and damages in civil lawsuits totaling $1 billion, Milken became one of several news-making, white-collar criminals of the 1980s. After his sentencing, the Wall Street Journalretracted its praise of the man, saying that "evidence now suggests that Mr. Milken's theory was wrong—and that he was far from the genius he seemed to be about junk bonds." (National Review, August 31, 1992). Milken's theory held that the high yields of junk bonds would draw investors to purchase many of them and that defaults on these securities would be few. The intense corporate competition of the 1980s waned; however, and in later years, investors moved away from junk bonds in search of other investment opportunities. Following his release from prison, after serving two years of his ten-year sentence, Milken was invited to lecture on ethics in business at the University of California, Los Angeles. To critics, however, Milken remained an icon of the money-mad 1980s, a financial wizard driven by the promise of vast wealth to push the limits of securities law. The one-time billionaire reemerged from prison with $300 million from his days as the king of junk bonds, which he used entrepreneurially in the education market, most notably as the brainchild behind Knowledge Universe, a company that owned several other education training and consulting companies, including the popular Leapfrog Enterprises (makers of LeapPad learning aids). Additionally, Milken became more visible in his philanthropic endeavors, particularly favoring prostate cancer research and Milken creations such as the Milken Family Foundation, the Milken Institute, and Mike's Math Club.

cross-references

Immediately after world war i, the U.S. economy rewarded investors who were eager to see expansions in industrial growth. For most of the 1920s, until just before the Great Depression, interest rates remained low. The bond market became sophisticated enough to raise funds for the U.S. Treasury, domestic corporations, and foreign borrowers. It also proved useful duringworld war ii, when the federal government depended on the sale of war bonds to finance its military efforts.

During the 1980s, a different kind of boom in the U.S. economy sent the bond market in a more problematic direction. Even though high-yielding bonds tend to be less reliable investments than low-yielding ones, the rapidly increasing business activity in the 1980s led to large-scale buying of these high-risk investments. Corporations successfully bought out the stock of other corporations by raising money through the sale of millions of dollars of junk bonds. (Junk bonds have been given low ratings when measured by standard investment criteria—hence the pejorative name.)

Troubles soon arose from the shaky foundation of the junk bond market. One of the country's leading figures in fostering junk bond investments, Michael R. Milken, faced criminal charges that he had manipulated bond prices, traded on inside information, and bribed investment managers. Milken's image was further complicated by his having worked with the stock baron Ivan F. Boesky, who had been convicted of insider trading. In April 1990, in Securities & Exchange Commission v. Milken, 1990 WL 455346, Fed. Sec. L. Rep. ¶ 95,200 (S.D.N.Y. April 24, 1990), Milken pleaded guilty to six felonies, including conspiracy, securities fraud, and aiding and abetting the filing of a false document with the securities and exchange commission. At the time of the initial settlement, Milken agreed to pay $600 million in fines and reparations. In November 1990, federal judge Kimba M. Wood sentenced Milken to ten years in prison. Milken served only two years of his sentence behind bars.

Problems have also arisen with bonds issued by governments. For example, when California's Orange County issued $169 million in municipal bonds in June 1994, future taxes and other general revenues were expected to pay for the interest and principal of the bonds. But on December 6, 1994, the county filed Chapter Nine petitions in bankruptcy court. The county could not pay the bondholders, since the money that had been set aside for them had been depleted. By 1995, losses in the Orange County investment pools approached $1.7 billion. Representatives of the county found themselves in court, being sued by the company that represented investors. In In re County of Orange, 179 B.R. 185, 26 Bankr. Ct. Dec. 1050 (Bankr. C.D. Cal. 1995), the bankruptcy court denied bondholders' claims to county revenues derived after the Chapter Nine filing. The interests of bondholders were seriously injured.

Nevertheless, bonds continue as popular investments. Junk bonds, especially, have regained favor as a means for earning considerable returns. The relatively high interest rates of junk bonds have entailed risks for buyers, but Wall Street analysts have argued that the rewards of these investment vehicles outweigh the dangers. Indeed, the bond market in general has even thrived in times of economic crisis.

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Bonds

Encyclopedia of Small Business
COPYRIGHT 2007 Thomson Gale

Bonds

Bonds are tradeable instruments of debt issued by institutions to finance their activities. Bonds have a face or par value (e.g., $1,000), a fixed interest rate also known as the coupon rate (e.g., 8 percent a year), and a maturity (e.g., 10 years). Bonds are routinely traded, i.e., sold and bought after the initial acquisition from the bond issuer. When a bond is sold at a rate higher than its face value, it is sold "at a premium"; when sold below face value, it is sold "at a discount." Trading in bonds is motivated by the coupon value of the bond in comparison with currently prevailing rates of interest, as discussed below.

Bonds are named after the issuing institutions. Best known are "treasuries," issued by the U.S. Treasury, "municipals," issued by municipalities and other levels of government, and "corporate bonds," issued by corporations. Municipals are tax-free; their earnings are not taxed, a special advantage. Other major categories are "mortgage bonds" issued by such agencies as the Government National Mortgage Association and the Federal Home Loan Mortgage Corporation, "federal agency bonds" issued by departments other than Treasury, "money market bonds" such as bankers' acceptances and commercial paper, and large time deposits, and "asset-backed bonds" where the bonds, issued by either private or public bodies, are tied to a specific object or activity.

TRADING IN BONDS

Just like stocks, bonds are actively traded. Why would a person holding a bond with a par value of $1,000 sell it for $800? Why would a person purchase a bond, par value $1,000, for $1,200? The determining factors are the components of the bonds (face value, coupon rate, and maturity) and the characteristics of competing securities and their fluctuating values.

To take "maturity" first, a ten-year bond ties up the invested amount for a ten-year period. An individual who, because of changing circumstances, needs to have cash now ("liquidity") can sell the bond to someone else. The purchaser will take advantage of the seller's situation by bidding less than the face value of the bond. The seller realizes cash immediately; the seller has a bond with a higher yield.

The yield of a bond is calculated by dividing its interest rate (which is fixed) by its face value (which can change when it is sold). When initially purchased, a $1,000 bond yielding $80 a year in interest has an 8 percent yield. If the bond is sold for $800, the yield becomes 10 percent (80 divided by 800). Conversely, if the bond is sold for $1,200, the yield drops to 6.7 percent (80 divided by 1200). Trading in bonds is based on a more complex formula called "yield to maturity." The calculation involves summing up all future yields until maturity, discounting future earnings to current value by using currently achievable interest rates, and deriving a new value. (The calculation is based on the general assumption that future earnings are worth less than cash in hand.) If the resulting "YTM" is higher than the owner of the bond can achieve by other means, he or she holds on to the bond; if not, the bond can be sold at a discount and the money reinvested elsewhere.

Because bonds have a par value and a fixed coupon rate, they are inherently safer than stocks. For this reason, bond prices tend to rise as stock prices drop and vice versa. A downturn in stocks brings money into the bond market; bonds with the most desirable features based on bond ratings, YTM, and tax-exempt status of earnings, tend to go up most. When stock surge, money tends to leave the bond market because greater appreciation is possible holding stocks than is possible to achieve by a combination of bond par values and yields.

BOND RATINGS

Bonds are rated by Moody's Investor Service, Standard & Poor's, Fitch Bond Rating Agency, and others. Using Moody's ratings, similar to S&P/Fitch ratings, Aaa is the highest quality rating, Aa is high quality, A is strong, and Baa is medium grade; all of the above are "investment grade." Ba, B is a speculative "junk grade" bond, Caa/Ca/C is a highly speculative junk bond, and a rating of C means a junk bond in default. S&P and Fitch use D to indicate a bond in default. The label "junk" in all cases indicates that the bond holder is in some kind of financial difficulty.

The higher a bond's rating, the lower will be its coupon rate. Junk bond issuers, by contrast, attempt to attract buyers by paying a high rate in compensation for the greater risks.

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Bonds

Gale Encyclopedia of U.S. Economic History
COPYRIGHT 2000 The Gale Group Inc.

BONDS

When a business or the government needs to raise a large amount of money for, say, corporate expansion or to build a new sports facility, it sells bonds to the public. A bond, then, is a financial instrument that represents a binding promise to pay the buyer of the bond the face or "par" value of the bond plus a definite rate of interest (known as the "coupon" rate) within a specific period of time (normally ten to thirty years). When a business or government issues a bond it is asking the public to lend it money, and in return for that loan it promises to pay bond holders interest, usually twice a year until the bond is paid back (known as reaching "maturity"). While a stock represents a piece of actual ownership in the company that can grow or shrink as much as the company underlying it does, a bond is an obligation to pay back a finite loan that the bondholder made to the company when he or she bought the bond. Bonds are a cheaper way to raise money because they are tax deductible.

Bonds have always played a critical role in the U.S economy. Because it issued war bonds, for example, the U.S. government was able to retire its debt established during the American Revolution (1775–1783) by 1835. Local governments began issuing municipal bonds in the nineteenth century as U.S. communities built canals and public highways. By the end of the American Civil War (1861–1865), 75 percent of the U.S. government's war debt was in the form of war bonds and similar instruments. A bull market in bonds lasted from the end of the Civil War until World War I (1914–1918), during which the government sold more than $21 billion in "Liberty loans" to U.S. citizens. This was the first time many Americans had ever owned paper securities (bonds or stocks), and it paved the way for a new group of middle-class investors who participated in the bull market of the 1920s. After the Japanese attacked Pearl Harbor in 1941, the U.S. Treasury quickly sold $2.5 billion in war bonds to U.S. citizens, and by 1944 alone it was selling $53 billion annually in war bonds. Both the government and corporate bond markets continued to grow and diversify after World War II (1939–1945), and today investors can own dozens of different bonds through bond mutual funds.

See also:Bear and Bull Markets, Interest, Liberty Bonds, Stock

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